The Basics of Exchange-Traded Funds (ETFs)

When it comes to investing your money, myriad options are at your disposal including stocks, bonds, mutual funds, certificates of deposit (CDs), annuities, and retirement plans such as 401(k) and 403(b) plans. While these are just some examples of the most common investment options, one alternative that has become more popular over the last 25-plus years is an exchange-traded fund—better known by the acronym “ETF.”

As a newer type of investment vehicle—the first American ETF launched in 1993—ETFs have grown in popularity in the United States, specifically: with investments growing from around $3.4 trillion in 2016 to over $10 trillion as of November 2021. The U.S. ETF market is expected to continue to grow significantly over the next few years, meaning this trend is showing no signs of slowing down.

What is an ETF?

Before we discuss the precise definition of an ETF, it’s important to understand what’s known as a “market index”: which tracks the price performance of a market, industry, or sector and is created by grouping a collection of assets (stocks, bonds, etc.) and tracking their cumulative value.

The Nasdaq Composite—a widely known index—is a great example of this, primarily tracking the performance of technology stocks and thus boasting a high concentration of technology companies within its holdings (such as Apple, Amazon, Meta, and Netflix). Another popular index—the Dow Jones—consists of 30 large, publicly traded companies that span a broad range of industries with holdings including Home Depot, McDonald’s, Walt Disney, and Microsoft. Perhaps by now you’re realizing there are literally thousands of indexes (in this country alone!) to choose from.

The point is that if you like the performance of a particular market index but don’t want to spend money buying individual stocks and/or invest the time needed to research and manage each one, an ETF allows you to replicate index performance at much less expensive rates.

With this context in mind, we can define an exchange-traded fund as a type of financial instrument containing a basket of securities (e.g., stocks, bonds, currencies, and commodities) while tracking to an index such as S&P 500, Dow Jones, or Nasdaq Composite.

One of the most well-known examples is the SPDR S&P 500 ETF (SPY). This ETF allocates almost all funds into common stocks included in the S&P 500 index, and one share is worth approximately 1/10th of the S&P 500’s current value.

In many ways, ETFs are similar to mutual funds as they both allow you to invest in a diversified portfolio by buying just one security—even adhering to many of the same regulations concerning fund ownership, how much they can borrow, and more. The difference between ETFs and mutual funds, however, lies in how they are managed.

Active vs. passive management

Before we delve into how mutual funds and EFTs differ from one other, it’s important to have a general understanding of active vs. passive portfolio management.

When an investment such as a mutual fund is actively managed (which is typically the case), this means a team of people (including a fund manager) actively try to outperform a specific benchmark such as the S&P 500. The idea here is for the fund to deliver performance that beats the market over time, even after fees are paid. However, to deliver such returns, active management not only requires a team of people to identify investment opportunities but also the frequent buying and trading of assets within the fund. Consequently, actively managed investments are not only more expensive to run but also force investors to pay higher fees.

On the other hand, passive investment management is designed to match (rather than exceed) the returns of a particular benchmark such as the S&P 500. Since this requires less human oversight and buying and trading on a less frequent basis, passive funds are generally automated—and thus much less expensive than actively managed funds.

Key differences between ETFs and mutual funds

Given that most ETFs are passively managed, they are often less expensive than mutual funds: making it no surprise that according to ETF.com, the average U.S. equity mutual fund charges 1.42% in annual administrative expenses while the average ETF charges just 0.53%.

Like stocks, ETFs are also bought and sold throughout the day on stock exchanges through a broker (hence the name exchange-traded fund). ETF prices are determined by the market and fluctuate throughout the trading day as shares are bought and sold. Conversely, mutual fund shares can only be transacted through a fund company and are bought and sold at day’s end: reflecting the same price paid by everyone else who made a transaction that same day; this is an important consideration for those seeking hands-on control regarding trading prices.

ETF investment advantages

Low fees and ease of trading are two primary factors fueling ETF growth. A few additional benefits include:

Transparency
ETFs provide investors with a higher level of transparency than mutual funds with respect to holdings, as the latter are only required to disclose their portfolios on a monthly or quarterly basis. This is important to highlight as a fund manager might choose to “style adrift”—thus straying away from their described targets and taking on unwanted risks. Most ETFs disclose their full portfolio holdings every day on various websites, providing investors with peace of mind.

Tax efficiency
ETFs are sometimes more tax-efficient than mutual funds mainly due to how securities in each investment are created and redeemed. We won’t get into specifics here for the sake of brevity, but mutual funds are generally structured in a way that tends to incur higher capital gains taxes.

Lower investment minimums
You can buy an ETF for the price of one share (values vary of course depending on the ETF). Minimal mutual fund investments, meanwhile, are often a flat dollar amount and start at $1,000 (on average) before climbing much higher.

Potential drawbacks of an ETF investment

As with most investment options, you’ll also need to consider some risks when investing in an ETF. These include:

Risk that an ETF will fold
In the off-chance that an ETF is closed and liquidated, this (occasional) occurrence means the fund didn’t bring in enough assets to cover administrative costs. While you won’t lose your money, you may end up selling sooner than you may have intended and thus run the risk of enduring unexpected tax burdens.

Trading costs
Mutual fund companies typically don’t charge a broker’s commission for buying and selling shares (although some do carry transaction fees). However, because ETFs are exchange-traded, they are sometimes subject to online broker commission fees. It’s therefore worth considering such fees—especially if you plan on buying small quantities of ETFs on a continual basis—so they don’t end up costing you far more than your management fee and tax efficiency savings.

In sum: ETF investments

Exchange-traded funds are often a viable option for many people, including young or beginner investors, as only a small amount of capital is required to jump in. However, as with most investment options, they do carry some risks. As selecting the right EFT for your needs might feel overwhelming—after all, Statista reports over 2,600 ETFs were available to choose from in the U.S. in 2021—it’s important to work with a qualified financial advisor who can help guide you and determine if (and how) specific options fit into your overall retirement plan.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.